LONDON Stock markets and southern European government bonds sank on Tuesday on fears that an electoral stalemate in Italy would leave its economic reform efforts in tatters and reignite the euro zone's broader debt crisis.
Italian shares lost as much as 5 percent of their value while 10-year bond yields saw the biggest jump in percentage terms this year after polls showed no single political force would have a majority in Italy's two houses of parliament.
A rally at the start of 2013 had encouraged hopes among policymakers that the euro zone was past the worst, but a steady flow of bleak news on its major economies has already undermined that faith.
Italy and Spain's ability to change the shape of their economies, get growth going and debt down have been at the heart of the euro zone's troubles for more than a year; the euro hit its lowest since the start of January against the dollar and stock markets in Germany and France fell by 2-3 percent, the most in almost a month.
"It looks like a mess to be honest with you, it doesn't look like we've got a workable government and the market is quite rightly on the defensive on this type of news," said Stewart Richardson, chief investment officer at RMG.
Yields on 10-year Italian government bonds rose by as much as half a percentage point to 4.86 percent in morning trade and the cost of insuring its debt against default surged by 45 basis points.
Some fund managers, however, were yet to be convinced that the election represented a major game changer for the euro zone and Italy as a whole.
"For the credit risk of Italy it doesn't change a thing for me. They will probably work out a weak coalition but it is not really endangering the credit standing of Italy," said Didier Duret, Chief Investment Officer at ABN Amro.
London's FTSE 100 was down 1.35 percent, while Paris's CAC-40 and Frankfurt's DAX down as much as 2.0 percent. The pan-European FTSEurofirst 300 index was down 1.0 percent.
MSCI's broadest index of Asia-Pacific shares outside Japan fell 0.9 percent sending the MSCI world equity index down 0.7 percent to 349 points.
The stocks selloff had begun late on Monday when exit polls and early voting trends signalled an inconclusive result, leading to the biggest percentage drop for the benchmark Standard & Poor's 500 Index on Wall Street since November7.
U.S. stock index futures, however, pointed to a slightly higher start when Wall Street reopens, with futures for the S&P 500, the Dow Jones and the Nasdaq 100 up 0.3-0.4 percent.
Virginie Maisonneuve, Head of Global and International Equities at Schroder Investment Management said the outcome was unlikely as yet to derail hopes of a gradual recovery for the euro zone as a whole.
"What's important is to understand is if, in fact, this (vote) against austerity is also against reform, which clearly is still very important to Europe and to Germany as well with the elections coming in September," she said.
Of greater concern to global growth prospects is the impact of sharp budget cuts due to take effect in the United States on Friday, and weak data on Monday from China showing a slowdown in its export-oriented manufacturing sector.
Investors were nervous before testimony later in the day from U.S. Federal Reserve Chairman Ben Bernanke, who could give further clues to when the central bank intends to slow down or stop its bond-buying programme.
Financial markets were rattled last week by minutes of the Fed's January meeting showing some officials were thinking of scaling back its monetary stimulus earlier than expected.
The growing uncertainty in the minds of many investors has led to a sharp rise in volatility with the CBOE's widely watched Vix Index .VIX jumping 34 percent on Monday for its biggest one day gain since August 2011.
Europe's equivalent index, the VSTOXX, which reflects options pricing and demand to protect against falls in the underlying cash market, rose 15 percent on Tuesday to hit a new year's high of 24.73.
The euro recovered some of its losses to steady at around $1.3080 to the dollar, up about 0.15 percent after falling as low as $1.3039, its lowest since January 10.
"For the euro, the focus is on the 2013 lows below $1.30 and events in Italy show that politicians are pushing back at fiscal austerity measures," said Paul Robson, currency strategist at RBS.
Brent crude joined the sell-off, falling to $113.26, its weakest since January 29, before steadying to be down 99 cents at $113.45. U.S. oil slipped 84 cents to $92.27, after touching a low of $91.92, a level not seen since January 4.
(Additional reporting by Toni Vorobyova, Peg Mackey and Anirban Nag. Editing by Alastair Macdonald)